A brave new world – new capital requirements for investment firms
By Harpartap Singh, Managing Consultant, Bovill
Published: 13 July 2018
Recent European Commission proposals for a tailored prudential regime for investment firms represent a significant change from the current approach to capital and liquidity.
Current rules and the road ahead
The current prudential rules, the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD IV) were introduced in June 2013 in the wake of the global financial crisis (the Regulation and Directive are together colloquially known as CRD IV). Despite being developed with banks in mind, CRD IV also applies to investment firms (albeit with some national exemptions for certain investment managers and advisers). For investment managers and advisers, capital requirements are usually driven by either the composition of their balance sheet, their fixed cost base or, in many cases, a minimum base requirement.
It was clear that the differing business models and risk profiles of investment firms simply didn’t fit well with CRD IV and resulted in a disproportionate regulatory burden being imposed on non-banks. As a result, the CRD IV mandated a review of the prudential treatment of investment firms. The EBA drafted recommendations for the European Commission in 2017 which then issued a draft Regulation on the prudential treatment of investment firms (IFR) and a Directive on the prudential supervision of investment firms (IFD) in December 2017.
Once the proposals have been discussed and accepted by the European Parliament and the European Council, they are expected to take another 18 months to come into force. This means the new regime may come into effect in Q1 2020
Wider scope
The new prudential regime will apply to all MiFID II firms. This is in contrast to CRD IV which only applies to MiFID firms that hold client money, operate a Multilateral Trading Facility (MTF), deal on own account, conduct underwriting or have opted in to MiFID.
Over a thousand firms in the UK (currently called exempt CAD firms, commodity investment firms and local firms) will for the first time become subject to many new prudential requirements.
Class
The current rules differentiate between 12 different categories of firm. The categories will be radically simplified to just three and be a function of firms’ size and activity, not just the regulatory activities it undertakes.
Class 1 firms will be those that are bank like or pose a systemic risk. These firms, which are all in the UK, will continue under CRD IV.
Class 2 firms will be those that conduct certain activities (for example, dealing on own account, hold client money or assets) or which exceed certain size limits (AUM > €1.2bn, handling client orders > €100m per day for cash trade or €1bn for derivatives, balance sheet > €100m, gross revenues > €30m). This is the class which will experience a fundamental shift in the method for calculating prudential requirements.
Class 3 firms will by default be those falling outside the Class 2 criteria. These firms will be subject to a stripped-down version of the new regime due to their lower levels of risk and complexity.
There are also provisions which enable firms to be re categorised.
How much capital will be required?
Class 2 firms will have to hold capital which amounts to the higher of three metrics:
- Permanent Minimum Capital (PMC),
- fixed overhead requirement (FOR) and
- the K-factor requirement.
PMC will be either €75k, €150k or €750k. It is simply dependent on the regulated activities of the firm and is not risk sensitive.
The FOR is based on 25% of a firm’s fixed annual expenditure. It is a proxy for the costs of winding down a firm and scales with it’s cost base.
The K-factor requirement is calculated using a risk-weighted formula for each type of activity the firm undertakes. It is calculated as the sum of the applicable K-factors - assets under management, client money held, assets safeguarded and administered, client orders handled, daily trading flows, net position risk, trading counterparty default and concentration risk. The last three factors only apply to firms which deal on their own account. The formula differentiates between cash trades and derivatives and also includes market risk, counterparty-credit risk and concentration risk elements.
The K-factor of most relevance to investment managers / advisers is the K-AUM factor. This applies at a rate of 0.02% of the monthly average of assets under management. For those firms which are AIFMs (Alternative Investment Fund Managers), that also perform MiFID activities or have AIFMs in their group, this will sound familiar. However, there are two key differences from AIFM prudential requirements. First, there is no upper cap on the amount of the K-AUM risk factor. Second, the preamble to the IFR states that the rationale for K-AUM is the “risk of harm to clients from…ongoing portfolio management and advice” which is wider in scope than under AIFMD. The next most relevant K-factor would be K-COH (client orders handled) which covers transactions executed by firms providing portfolio management on behalf of investment funds.
Class 3 firms will only have to apply the higher of the PMC and FOR and don’t have to worry about the K-factor formula at all.
Securitisations
At present, firms which want to invest in securitisations can only do so if the originator, sponsor or original lender discloses to the firm that it has retained an ongoing net material interest of at least 5%. This restriction does not appear to apply under the IFR.
Firms which invest in securitisations on their own behalf or are themselves originators or sponsors, will no longer have to apply any haircuts to such positions under IFR. This may present an opportunity to free up capital.
Mandatory liquidity requirements
Both Class 2 and 3 firms will have to maintain liquid assets of at least one third of their fixed overhead requirements. Liquid assets are limited to unencumbered cash and Level 1, 2A and 2B liquid assets as defined for the purposes of the Liquidity Coverage Ratio under CRR.
Class 3 firms will, however be able to cover up to a third of their liquidity requirement with trade debtors and fees and commissions receivable, subject to a 50% haircut.
Additional reporting and public disclosures?
Class 2 firms will have new annual reporting requirements on a range of matters beyond their existing capital reports covering capital requirement calculations, activity levels in respect of the Class 2 conditions, concentration risk and liquidity requirement. Class 3 firms will have it slightly easier because they will not have to report on concentration risk or liquidity.
The annual frequency will be a welcome relief for many firms used to quarterly or half yearly reporting but the detailed requirements of what has to be reported are yet to be developed by the EBA and ESMA.
Turning to public disclosures (Pillar 3), Class 2 firms will have disclose information on six areas:
- risk management policies,
- governance,
- own funds,
- capital requirements,
- return on assets and
- remuneration policy.
Some of these disclosures are the same as now but there are some differences such as disclosure of a firm’s FOR and, if requested by the regulator, results of the ICAAP (firm’s own capital assessment) and any additional capital requirement imposed by the regulator as part of a supervisory review process. Class 3 firms will have a much easier ride, since they will not have to make Pillar 3 disclosures.
What should you do?
Fortunately, there will be a five-year transitional period to provide some temporary relief. During this time, many firms will still see changes by steps in their regulatory capital burden along with the need to cope with the more complex calculations.
Firms should carefully consider what category they are likely to fall into, taking into account current and future business plans and the consequential effects on their capital adequacy and prudential obligations. Now is the time for firms to plan for the potential impact, which could be significant.
Of course, you might ask if this is something to worry about with Brexit on the horizon. In our view, yes, absolutely; the UK will want to meet equivalence standards and therefore, you should expect UK regulation to be the same or at least very similar to that in Europe.
To contact the author:
Harpartap Singh, Managing Consultant at Bovill: [email protected]
